The Fed's Great Stress Test Show

Later Thursday, we're going to get the first round of results from the Federal Reserve's stress tests, which will show broadly how the Fed thinks the banking sector would look under crisis situations.

Critics will complain that this is all just for show. But this complaint largely misses the mark. In large part, the stress tests are a show. And that's part of the point.

The tests are real attempts to measure how individual banks would fare under stressful circumstances. In that sense, the tests are part of the Fed's supervisory function.

But they are also an attempt to demonstrate to the market that financial institutions and the system itself are healthy enough to withstand stress. That its, the tests have a communicative function as well as a supervisory one.

During the financial crisis, it became all too obvious that investors and counterparties had lost faith in statements by the banks themselves about how robust their liquidity and capital provisions were. A bank executive saying that his firm was adequately capitalized or had plenty of liquidity tended to backfire—the market often would immediately read the reassurance as a reason to run.

What's more, investors and counterparties during the crisis began using more stringent measures than regulators to assess the financial health of banks. Bank executives complained loudly about being held to new standards that weren't aligned with regulatory requirements. But they quickly learned that when the market requires more than regulators, you'd better be willing to make the market happy or face the consequences.

In other words, before we had regulatory stress tests for banks, banks were tested by actual stress. The hope is that when actual stress arrive, the regulatory tests will have prepared them for it.

The tests are an attempt to restore confidence in institutions and the system, now that trust in statements by individual bank executives are widely distrusted. In effect, the Fed is leveraging its own credibility to replace the lost credibility of the banks.

The Fed quite explicitly built the stress tests around market expectations. The thinking was that if a bank's capital fell below 5 percent Tier 1 common equity in a stressful situation, market participants would refuse to engage with the bank and funding would quickly evaporate.

"During the stress test exercises associated with the Federal Reserve's annual Comprehensive Capital Adequacy Review (CCAR) program we have required that bank capital exceed 5 percent Tier 1 common equity over the forecast horizon, based on the premise that such a buffer would be required for financial firms to fully operate and maintain investor and counterparty confidence during stressful periods," Boston Fed President Eric Rosengren said in a recent speech.

In other words, the Fed has built the tests not just around the capital it thinks a bank needs—but around what it expects the market will require. It has learned at least that lesson from the crisis: In a stress period, the market's tests for a bank's health can exceed the formal regulatory requirements for being "well-capitalized."

Of course, the Fed might be under-estimating either the losses from stressful markets or the amount of capital investors and counterparties will require. There's a lot of guess work that goes into measuring these things. It's not clear that our models today are all that much more reliable than the models in place before the crisis.

The great danger here is that the Fed's credibility is on the line. If a bank that passes the stress test fails in some dramatic and messy fashion, the Fed's policy could backfire. Immediately, the confidence in the system could be shaken. Healthy banks could find themselves under a lot more than stress.